The Economics of Health Care
THE ECONOMICS OF HEALTH CARE
This chapter addresses one of the most prominent economic and political issues of our time. Providing
health care is an economic issue, and the American public‘s concern ranges from the problem of rising
health care costs, to gaps in health insurance coverage, to government insurance programs draining
Federal and state budgets. The debate over the desirability of more government involvement in
providing health insurance continues.
Chapter 36 examines the economic aspects of our health care problems, offers a demand and supply
analysis to explain rapid increases in health care costs, and evaluates some methods of containing
increases in health care costs.
The structure and central topics of the chapter have not changed, but there are a number of revisions.
Most of them involve updating data or expanding discussions based on changes in institutions, laws, or
medical knowledge. The Health Care Financing Administration is now the Centers for Medicare and
Medicaid Services. Discussions of the value added from improved longevity, the effect of overeating and
inactivity on illness, prescription drugs as improvements in medical technology, and a number of policy
changes have been added.
A “Consider This” box has been added that provides an example of how technological changes
contribute to rising health care costs.
There is a new end-of-chapter question, the “Last Word” question is now a web-based question, and the
web-based question on AARP has been replaced with one on health expenditures per capita.
After completing this chapter, students should be able to
1. Describe what is meant by the health care industry and approximate its size with relevant data.
2. Identify the problem connected with rising health care costs.
3. Give the negative effects associated with rising health care costs.
4. Explain what is meant by the overallocation of resources to the health care industry.
5. Describe the extent of the problem regarding a lack of health insurance coverage.
6. Identify four special characteristics of the health care market.
7. Give four factors that have contributed to the rise in the demand for health care.
8. Explain the role of physicians in increasing the demand for health care.
9. Explain the “moral hazard” problem arising from health insurance coverage.
10. Explain how the Federal income tax structure subsidizes health care demand.
11. Identify three supply factors that contribute to rising health care costs.
12. Identify three basic reform proposals designed to increase access to health care.
The Economics of Health Care
13. Explain what National Health Insurance is.
14. Present the arguments for and against National Health Insurance.
15. Explain how insurance company deductibles, co-payments, and preferred provider organizations
might help contain health care costs.
16. Outline the recent laws passed by Congress and some of proposals before Congress.
17. Define and identify terms and concepts listed at the end of the chapter.
COMMENTS AND TEACHING SUGGESTIONS
1. There is a wealth of information available on health care in the popular press. This topic provides
an excellent opportunity for student debates, papers, and presentations. Because it is an issue that
concerns so many of us, you can easily get students to relate their personal experiences to the
economics of health care. Once you have their interest, you can relate their concerns to many of
the theoretical and structural concepts raised in microeconomics. The material can also be used to
help students better appreciate the macroeconomic tradeoffs, especially as they pertain to health
care reform proposals.
2. The National Issues Forum has some excellent teaching materials that provide a focus for
discussing some of the major issues. Related to this chapter are two of their topics, “The Health
Care Cost Explosion: Why It’s So Serious, What Should Be Done, “ and “Health Care for the
Elderly: Moral Dilemma, Mortal Choices.” This organization also has units that focus on
“Coping with AIDS” and “The Drug Crisis,” which may be useful supplements in a more
interdisciplinary course. For more information about their issue books, audiocassette tapes, and
videocassettes, call 1-800-433-7834 or write to them at 100 Commons Road, Dayton, Ohio
3. The Nebraska Council on Economic Education has an excellent set of activities, suitable for
secondary or college-level classes, which revolve around the economics of health care and are
available for about $10. They also have a video, “Code Blue,” of a teleconference panel
highlighting some of the major issues. For more information call 1-800-328-2854 or
402-472-2333 or FAX 402-472-9700.
4. The health care industry can be analyzed from the perspective of market structure, which
reinforces what students have just learned about the different market models, from perfect
competition to pure monopoly. How do the markets for various types of health care services fit the
various market models? If the market being examined does not fit the competitive model, or if
consumers pay indirectly through prepaid insurance plans, does it make sense to talk about market
solutions? If market solutions are possible, should reforms be aimed at enhancing competition?
The health care industry, or particular components of it, provide excellent opportunities for using
the case-study method to teach economic concepts.
5. Price elasticity and income elasticity of demand both play an important role in the problems of the
health care industry. Most health care services are a necessity with few substitutes, making the
demand for them relatively price-inelastic. This fact means that rising costs of production that
decrease supply will have more impact on the price of health care than on the quantity purchased.
Health care is a normal good, meaning that as incomes rise the demand for health care will also
increase. Employing this chapter as a demonstration when studying the theory of elasticity in
Chapter 20 can be an effective combination.
6. The discussion of health care can lead easily to the discussion of how we value human life. A fun
and illuminating exercise is to place students on “organ donation” boards, where they (in small
groups) must decide which candidate receives a vital organ (the nonrecipients die). Write profiles
for four or five prospective recipients, assume that all have the same level of compatibility with the
The Economics of Health Care
donor’s organ, and include information such as age, reason for organ need (genetics, unhealthy
lifestyle, accident, etc.), annual income (or prospective annual income for students), and family
situation (single, married, children, etc.). These are of course hypothetical, but for an added bit a
fun write profiles of what would happen to each candidate if he or she received the organ (brilliant
student flunks out, welfare recipient goes on to win Nobel Prize, and so on).
STUDENT STUMBLING BLOCKS
Do not assume your younger students know anything about health insurance coverage, even at the
personal level. Unless they have encountered some problem, it is probably one of those economic costs
that they have ignored, since they are covered by their parents’ insurance or the university health center.
The students who have encountered some problem with coverage will help you “open other students’
A. The high costs of health care in the United States are frequently the subject of news reports.
1. People without health insurance.
2. Federal and state budgets strained by health care costs.
3. Labor dispute over health insurance.
4. Insurance companies dictating the medical care doctors can provide.
5. Ethical questions concerning the acutely or terminally ill.
B. This chapter focuses on several issues.
1. The United States system of health care.
2. The economics of health care costs.
3. Actual and proposed reforms.
II. The Health Care Industry
A. Government’s definition of this far-reaching industry includes many aspects.
1. Services provided in hospitals, nursing homes, labs, physicians’ and dentists’ offices.
2. Prescription and nonprescription drugs, artificial limbs, and eyeglasses.
3. Services of many nontraditional practitioners, but not fitness club services, or health
B. The size of the industry is immense.
1. Nine million are employed in the industry, including 700,000 physicians.
2. There are about 5,800 hospitals with almost 1 million beds.
3. Health care accounts for more than 14 percent of GDP.
III. Twin problems: cost and access
A. Health care costs include the “price” of health care as well as the “quantity” of health care
The Economics of Health Care
B. Health care costs have been rising rapidly because of higher prices and an increase in the
quantity of services provided. The price of medical care has been increasing far faster than
the overall price level.
C. Efforts to reform health care have focused on controlling costs and increasing accessibility.
A dual system of health care (one for those who can afford to pay and the other for those
who cannot) may be evolving.
IV. High and rising health care costs.
A. Health care spending in the U.S. is rising in absolute terms, as a percentage of domestic
output, and on a per capita basis.
B. Figure 36-1 shows major types of spending and major sources of funds for these
1. Thirty-three cents of each health care dollar is spent on hospitals; 22 cents goes to
physicians; 22 cents goes to dental and vision care; and 23 cents pays for other health
care services, including prescription drugs, home care, and program administration.
2. About 80 percent of expenditures are paid for by public and private insurance; the
remaining amount is paid by the health-care consumer.
C. Health care absorbed 5.1 percent of GDP in 1960, 14.1 percent in 2001, and is projected to
increase to 16.4 percent by 2008. (See Figure 36-2.)
D. Global Perspective 36-1 shows that per capita spending on health care is higher in the U.S.
than in any other major industrialized nation.
E. Quality of care: Are we healthier?
1. Medical care in the U.S. is probably the best in the world, but not our health.
2. As a result of medical research, the incidence of certain diseases has been declining and
the quality of treatment has been improving in the U.S. But the U.S. has a lower life
expectancy, higher maternal mortality and infant mortality rates, an AIDS epidemic that
has claimed over 486,000 lives, and an increase in tuberculosis.
3. The U.S. Office of Technology Assessment has concluded that the U.S. ranks low
internationally on may health indicators.
F. There are economic implications of rising costs.
1. The increase in health care costs is the main reason for rising health care spending.
2. Increased health care costs have other effects as well.
a. Fewer uninsured workers can afford health care; fewer employers can offer health
insurance to workers.
b. Adverse effects on labor markets exist.
i. Wages grow more slowly because health care benefits are taking a larger share
of the “compensation” package.
ii. Employers use more part-time and temporary workers to avoid the high cost of
health insurance coverage for workers. Employer may contract-out the work of
low-paid workers to avoid paying health care costs.
c. Government budgets at all levels have to deal with spiraling health care
The Economics of Health Care
i. Medicare and Medicaid has been the fastest growing segment of the Federal
ii. Higher taxes or reductions in other budget components (national defense,
education, environmental programs) must be used to cover the increases.
iii. States are finding it difficult to cover their share of Medicaid costs and must
reduce other expenditures (infrastructure, education, and welfare).
iv. Local governments face similar strains.
G. A basic allocation problem.
1. Most industries are happy to have increased spending. Why are we alarmed about more
spending on health care? According to economist William Nordhaus, the economic
value of increased longevity is roughly equal to the increased GDP over the last 100
years. Despite this, economists see health care expenditures as inefficiently large, a
product of the unique features of the health care market.
2. Experts are concerned that at the margin, the consumption of health care is worth less
than the alternative goods and services that could otherwise have been produced with
those resources. In other words, there is an overallocation of resources to health care,
which imposes a real economic cost on society.
V. Limited access: Many are uninsured.
1. In 2001 about 41 million Americans (15 percent of population) had no health insurance
for the entire year. About 75 million people were uninsured at some point in 2001 or
2002. This number grows as health care costs rise.
2. Which groups have no insurance?
a. Fifty percent of the uninsured are families where the head works full time, the family
income is too high to qualify for Medicaid, but the earned income is not enough to
afford health insurance. Many are single-parent families, African American, or
b. Young people with excellent health choose not to buy health insurance.
c. The chronically ill find it impossible or too costly to obtain insurance because of the
likelihood they will incur substantial costs in the future.
d. The unemployed lack insurance because most policies accompany employment.
e. Workers for small firms are unlikely to have insurance because high administrative
costs make it costly for small business employers to offer this benefit.
f. Part-time and low-wage workers are also less likely to be insured.
3. The uninsured will sometimes pay directly, but often wait until their illness is so critical
that the hospital emergency room is the only alternative, and this adds to hospitals’
uncompensated health care burdens, estimated at $20-25 billion per year. Hospitals are
forced to shift these costs to other health-care customers.
VI. Why the rapid rise in costs?
A. The health care market is unique.
1. Ethical and equity considerations are intertwined. Society regards much of health care as
a right and is reluctant to ration it solely on the basis of who can afford it.
The Economics of Health Care
2. Information is asymmetric: Physicians and other caregivers possess more information
about the product than the consumer. Often the provider orders the service for the
consumer or patient.
3. Spillover or external benefits exist. Healthy individuals make the entire society more
productive and contribute to general prosperity and well-being.
4. Third-party payment or payment by the insurance company means that the consumer has
little or no direct out-of-pocket expenditure for health care services. Therefore, the
consumer does not seek out the lowest cost alternative.
B. The demand for health care has been increasing.
1. Health care is a “normal” good, so when incomes rise, the demand for health care rises
proportionately. Elasticity with respect to income is estimated to be about 1 and may be
as high as 1.5 in the U.S.
2. Demand for most health care is believed to be price “inelastic,” which means that the
quantity demanded does not decline with rising prices.
a. Most health care is a necessity.
b. There are few substitutes for most health care services.
c. Consumers do not “shop around” for doctors in most cases.
d. Patients with insurance do not care much about the price of each service received
since they prepay for the total package.
3. The population is aging. By 2000 the proportion those over age 65 had risen to 12.4
percent from 9 percent thirty years earlier. Those over 65 consume 3 1/2 times more
health care services as those between 19 and 64. By 2030 the proportion of the
population over age 65 will be almost 20 percent.
4. Unhealthy lifestyles, particularly substance abuse, are common, although smoking is
5. The role of physicians may increase the demand for health care.
a. Supplier-induced demand. Asymmetric information exists, meaning that doctors
possess more information about health care needs than do their patients (consumers)
and doctors order the services for them. Also doctors are paid on a “fee-for-service”
basis, which encourages them to order more services, and patients seldom have
advance information on the cost or necessity of these services.
b. Defensive medicine is common in that doctors err on the side of being overly
cautious to avoid any charges of malpractice. They often order many procedures that
may not be necessary.
c. Medical ethics cause doctors to use the “best practice” to serve their patients and to
try to sustain human life regardless of cost.
6. Insurance pays about 78 percent of health care costs. While this is positive in providing
security against devastating losses, it creates a “moral hazard” problem.
a. Insured may seek more health care and engage in more damaging behavior than the
b. Overconsumption occurs because people regard health care as “free,” since they
have prepaid for their services.
The Economics of Health Care
c. Price provides a direct incentive to restrict the use of a product, but insurance
coverage, removes the consumer’s budget constraint when he or she decides to
consume health care.
7. Employer-financed health insurance constitutes a “tax subsidy” because the health
benefits are exempt from both federal income tax and payroll (social security) taxation.
8. Figure 36-3a gives graphic portrayal of a competitive health care market (on the demand
side) that might exist if all consumers were uninsured. Allocative efficiency occurs only
when we pay in full for a product. In Figure 36-3b we see the effect of health insurance
paying half the price of health care, so the consumer’s bill for the service is the same as
half price. Therefore, the quantity consumed will be Qi rather than Qu and there is more
health care consumed than would be justified by the total cost of this amount of care to
society. Figure 36-3b illustrates this “welfare loss” be the area abc.
9. The “equity-efficiency” tradeoff is illustrated here. The dilemma is that if we provide
social insurance that is believed equitable, then overconsumption will occur, which is
inefficient. Efficiency may be achieved when less insurance is provided, but this may be
C. Supply factors also cause rising costs.
1. Some believe that the supply of physicians has been restricted artificially, but the
evidence for this argument is not strong, since the number of physicians per 100,000
people has increased over the years. But the increase in the supply of physicians has not
kept up with the increase in demand for services provided.
2. Physicians’ incomes are high in part because of the high costs incurred during their
education. Although doctors have high rates of return on their educational expenses,
these returns are below those for lawyers and business school graduates.
3. Productivity growth has been slow in health care because it is labor intensive and there is
no strong incentive to raise productivity in a fee-for-service system.
4. Changes in medical technology have often caused rising costs, because private and
public insurance pays for new technology regardless of costs. Some studies estimate that
this accounts for as much as one-half of the growth of health care expenditures.
CONSIDER THIS … What’s Cold, Clammy, and Out of Date?
D. Relative importance.
1. Health care costs have escalated because of both demand and supply side factors as
enumerated above; however some factors are more important than others.
2. Most experts attribute the relative rise in health care spending to the following:
a. Advances in medical technology.
b. The medical ethic of providing the best treatment available.
c. Private and public health insurance (the presence of third party-payers).
d. Fee-for-service physician payments.
V. Reforming the Health Care System
A. Again, the two goals of health care reform are containing costs and increasing access. There
are tradeoffs between these two goals.
B. Achieving universal access is one goal. Three proposals have been considered.
The Economics of Health Care
1. “Play or pay” is the name given to a proposal in which employers would be required to
provide a basic health insurance program for their workers and their dependents (play) or
pay a special payroll tax to provide health insurance for uninsured workers (pay).
a. This may lower real wages on the one hand.
b. It may also lead to more job mobility on the other hand.
c. Some fear it could lead to a rise in unemployment for low-wage workers.
2. Tax credits or vouchers offer another approach. Tax credits would be given to low-
income families to purchase health care coverage, or a voucher would be issued to the
3. National health insurance is the most far-reaching proposal. It is not “socialized”
medicine, because the government would not provide health care services, only insure
a. Proponents say it is the simplest and most direct way to provide universal access, it
allows patient choice; it reduces administrative costs (administrative costs are 5
percent of total health care costs in Canada, while they are currently about 17 percent
of health care costs in U.S.); it increases labor mobility, since health insurance is not
tied to the job; and it would give government power to contain costs.
b. Opponents argue that government price ceilings will not contain costs—-doctors
would have too many loopholes; that Canada’s system has waiting lists for certain
types of procedures and that technology is not as available as in U.S. today; that the
Federal government does not contain costs in other areas very successfully; and that
health insurance coverage would become a sort of progressive tax benefit program,
since low-income groups would pay little and workers in other industries might find
themselves with more take-home income if their employers saved with national
C. Cost containment: One solution is to alter incentives.
1. Deductibles and co-payments reduce the overconsumption problem, since the insured
have higher out-of-pocket costs. Administrative costs have been reduced by eliminating
2. Managed-care organizations are those in which medical services are controlled or
coordinated by insurance companies or health care organizations in order to reduce
health care expenditures.
a. In 2001, about 65 percent of U.S. workers received health care through managed-
b. Preferred provider organizations (PPOs) give breaks to insurance companies,
which rewards the insured for using members of PPO with smaller co-payment
c. Health maintenance organizations (HMOs) offer prepaid health plans, which
give incentives to the organization to hold costs down, and encourage preventive
d. With both PPOs and HMOs, medical services and spending by physicians and
hospitals are monitored.
e. The disadvantages of managed care from the patient’s perspective is the focus on
reducing costs by denying expensive but effective treatment. A “patients’ bill of
The Economics of Health Care
rights” is still being negotiated between the Senate and House of
3. Medicare reimburses hospitals based on categories of procedures that characterize a
patient’s condition rather than on what the physician or hospital say is needed regarding
length and type of hospital care. This is known as diagnosis-related-group (DRG)
D. Recent laws and proposals.
1. Although Congress has rejected major reforms, it has made some modest changes and is
a. The Health Insurance and Portability Act of 1996 ensures that workers with a group
health plan can continue to buy health insurance when they change jobs or become
self-employed and prohibits group insurance plans from dropping coverage of a sick
employee or of a business that has a sick employee.
b. Medical savings accounts were introduced in 1996 on a trial basis. These tax
deductible accounts can be used for routine medical expenses and include a
catastrophic health insurance plan for large medical expenses. Critics contend that
the accounts create an adverse selection problem by pulling the healthiest and
wealthiest away from the general insurance market.
c. A “patients’ bill of rights” was passed in 2000 to regulate HMOs and protect patients
by guaranteeing access to emergency and specialty care, provide quick review of
denied medical procedures, and allow families to sue HMOs for actions leading to
injury or death. However, the U.S. Senate and House of Representatives passed
different versions of the bill, and as of 2003 still had not negotiated a final version.
d. Limits on malpractice awards will reduce premiums on malpractice insurance and
reduce the number of unnecessary tests that doctors perform out of fear of being sued
for missing a diagnosis. Opponents argue that the threat of large “pain and
suffering” awards deter medical malpractice.
e. Prescription drugs are not currently (2003) covered by Medicare, but the coverage
has growing Congressional support. There are several reasons for this increased
i. Prescription drugs are becoming a larger portion of health care spending
particularly for the elderly.
ii. Politicians are aware of the popularity of a prescription-drug benefit among the
Americans on Medicare.
iii. Despite this support, there are concerns over the impact on the federal budget
and on whether the coverage should extend to all Medicare recipients, or only
those of low income.
f. Medicare reform was proposed by the Bush administration in 2003. It would provide
options for different levels of care. One could opt for a basic managed-care plan
with prescription drug coverage, or pay supplemental premiums for more extensive
(and more expensive) coverage.
The Economics of Health Care
VI. LAST WORD: A Market for Human Organs?
A. Advances in medical technology make it possible for surgeons to replace some human body
parts with donated “used parts.” But not everyone who needs a transplant can get one. In
2003, there were 81,000 Americans on the waiting list. It is estimated that there are 4000
deaths per year in the U.S. because not enough organs are available.
B. Why shortages?
1. No market exists for human organs.
2. The demand curve for human organs would resemble others in that a greater quantity
would be demanded at low prices than at higher prices.
3. Donated organs that are rationed by a waiting list have a zero price. The existing supply
is perfectly inelastic and is the fixed quantity offered by willing donors.
4. There is a shortage of human organs because at a zero price the quantity demanded
exceeds the quantity supplied.
C. Using a market.
1. A market for human organs would increase the incentive to donate organs. The higher
the expected price of an organ, the greater would be the number of people willing to have
their organs sold at death.
2. The shortage of organs would be eliminated, and the number of organs available for
transplanting would rise.
1. The first is a moral objection that turning human organs into commodities
commercializes human beings and diminishes the special nature of human life.
2. An analytical critique based on the elasticity of supply, suggests that the likely increase
in the actual number of usable organs for transplants would not be great.
3. A health-cost concern suggests that a market for body organs would greatly increase the
cost of health care.
E. Prohibitions on a human organ market have given rise to a worldwide, $1 billion-per-year
illegal market. There is concern that those willing to participate in an illegal market such as
this may also be willing to take extreme measures to solicit organs from unwilling donors.
ANSWERS TO END-OF-CHAPTER QUESTIONS
36-1 Why would increased spending on, say, household appliances or television sets in a particular
economy be regarded as economically desirable? Why, then, is there so much concern about
rising expenditures as a percentage of the GDP on health care?
Increasing expenditures on goods such as household appliances or television sets is regarded as
desirable because production is expanding under relatively competitive market conditions. Thus,
not only are output and employment expanding, but presumably these are happening because of
allocative efficiency. Consumers are choosing to buy appliances or televisions because they are
willing to pay the price for these goods.
There is concern about the same rising expenditures in the health care industry because of the
unique factors that characterize the market for health care services. On the demand side, there is
imperfect competition in that buyers do not have good information about the services needed or
the fees that will be charged for the services; doctors control much of this information and, in
The Economics of Health Care
fact, order the services for the consumer in most cases. Third-party insurance companies pay the
direct costs of most health care on a fee-for-service basis, and therefore the consumer pays less
than the full price at the time of consumption, leading to overconsumption; overconsumption by
the insured may also be encouraged by the “moral hazard” problem. On the supply side,
technology is encouraged without much regard for its cost by insurance providers; doctors also
control much of the provision of health care in an imperfectly competitive supply structure, since
they really don’t compete on the basis of price. In other words, many of the unique factors of the
health care market lead economists to believe that overconsumption is occurring and that society
is losing because resources are not being allocated efficiently in a way that maximizes society’s
36-2 (Key Question) What are the “twin problems” of the health care industry? How are they related?
The “twin problems” are rising prices for all and limited access (lack of insurance) for about 16
percent of the population (41 million). The problems are related since rising costs make
insurance unaffordable for many individuals and families, and make it difficult for some
businesses to insure their workers.
36-3 Briefly describe the main features of Medicare and Medicaid, indicating how each is financed.
Medicare is a nationwide Federal health care program available to social security beneficiaries
and the disabled. It consists of a hospital insurance program and certain other coverage for post-
hospital care. It also includes a subsidized medical insurance portion ($58.70 per month in 2003)
for physician services, lab tests, and other outpatient services. The hospital portion is covered
through payroll taxes, the same as social security. The medical portion is covered as stated, with
about three-fourths of the cost being covered by the government.
Medicaid provides payment for medical benefits to certain low-income people, including the
elderly, blind, disabled, children, and adults with dependent children who qualify. Nevertheless,
it covers less than half of those in poverty.
36-4 What are the implications of rapidly rising health care costs for (a) the growth of real wage rates,
and (b) government budgets? Explain.
The real total compensation package, wages plus benefits, can only rise as fast as productivity
does. If health insurance benefits rise more rapidly than productivity, then the real wage
component of the compensation package is squeezed and it must fall. Workers feel the burden of
rising health care costs as their take-home wages fall.
Government budgets are also stretched by rising health care costs, because social security
recipients qualify for federally financed Medicare benefits, which grow as a result of higher
health care costs and a greater proportion of the population qualifying for these benefits. All
levels of government are affected by Medicaid payments, which are financed by a combination
of state and federal funds. Finally, local governments may also be affected through their support
of public hospital and other health care facilities, because the uninsured and underinsured need to
have their health care costs subsidized.
36-5 Who are the main groups without health insurance?
One group of uninsured is the working poor, who make too much to qualify for Medicaid but not
enough to afford health insurance. Both they and their employers find it difficult to support this
cost for minimum-wage and other low-income workers. Another group includes part-time
workers and those who work for small firms, or who are self-employed in small businesses or on
farms. Those who believe they are healthy and can avoid accidents, such as young adults, may
refuse to spend money on insurance, and on the opposite extreme, the chronically ill, who are
unable to get insurance coverage at all or at any reasonable price, are often without insurance.
The Economics of Health Care
36-6 List the special characteristics of the U.S. health care market, and specify how each affects health
The health care market has many characteristics that differentiate it from a perfectly competitive
market. (1) There are ethical questions connected with health care services that don’t arise when
people are unable to afford other types of goods and services—in general, society regards access
to basic health care as a right. (2) Buyers of health care typically have little information about
the services they need and should acquire, creating the unusual situation in which the doctor
(supplier) orders the services for the patient (consumer). (3) There are significant spillover or
external benefits connected with health care, suggesting that society should be willing to pay
more than the amount coming from the private sector alone. (4) Third-party payments are
common because the patient (consumer) has prepaid for insurance benefits, and about three-
fourths of all health care expenses are paid in this way. Consumers directly pay lower “out-of-
pocket” expenses than if they were not insured, which causes them to overconsume.
36-7 (Key Question) What are the estimated income and price elasticities of demand for health care?
How does each relate to rising health care costs?
Income elasticity is 1.0, suggesting that health care spending will rise proportionately with
income. Some studies indicate that it might be 1.5 in the U.S. Price elasticity is only 0.2,
meaning higher prices for health care services will increase total health care spending.
36-8 Briefly discuss the demand and supply factors that contribute to rising health costs. Specify how
(a) asymmetric information, (b) fee-for-service payments, (c) defensive medicine, and (d)
medical ethics, might cause health care costs to rise.
(a) Asymmetric information refers to the fact that consumers of health care often have very little
understanding of or access to the information about the health care services that they need.
Therefore, they must depend on health care professionals to order the services for them.
This creates the unusual market situation in which producers have the power to create
demand for what they produce. Even when patients understand and do create the demand, it
is difficult for them to find price information about health care services. Obviously this
situation is not a competitive one on the production side, and consequently there is less
pressure to keep prices low, as would be the case in a competitive industry.
(b) Fee-for-service payments can contribute to rising health care costs by making it possible for
providers to increase their incomes by simply ordering more services for the patient. If an
attempt were made to legally control prices, for example, the provider could simply require
the patient to purchase more tests, more exams, etc. The administrative costs of billing on a
fee-for-service basis are also higher than would be the case if there were other types of
reimbursement for services.
(c) Defensive medicine refers to the practice that physicians follow to avoid malpractice
charges. To defend against such concerns, they may order more tests and procedures than
would be warranted medically or economically.
(d) Medical ethics, which require the “best practice” techniques, may result in the use of costly
medical practices with only marginal benefits. Also, the values that promote the support of a
human life as long as possible, regardless of the cost or condition of life, add to the cost of
36-9 “Health care expenditures have been rising principally because of the technological
transformation of medical care.” Do you agree? Explain.
Significant advances in medical technology have occurred and have been encouraged by the
willingness of public and private insurance to pay for new treatments without regard to cost.
There appears to be an interplay among the availability of new medical technology, increases in
The Economics of Health Care
health care costs, increases the demand for health insurance, and finally increases in the demand
for the new services. This process is continuous. One illustration of this occurred when
Medicare programs agreed to pay for magnetic resonance imaging (MRI) scans in 1985; the sales
of such scanners then rose dramatically.
Many experts agree that as much as one-half of the increase in health care expenditures is the
result of advances in medical technology.
36-10 (Key Question) Using the concepts in Chapter 21’s discussion of consumer behavior, explain
how health care insurance results in an overallocation of resources to the health care industry.
Use a demand and supply diagram to specify the resulting efficiency loss.
Health care insurance removes or greatly lessens a person’s budget restraint at the time health
care is purchased, raising health care utility per dollar spent and causing an overconsumption of
health care. In Figure 36-3b, insurance reduces the price of health care at the time of purchase
from Pu to Pi, increasing the quantity consumed from Qu to Qi. At Qi the marginal cost of
health care is represented by point b and exceeds the marginal benefit represented by c,
indicating an overallocation of resources. The efficiency loss is area cab.
36-11 How is the moral hazard problem relevant to the health care market?
The moral hazard problem is relevant to the health care market in two basic ways. First, the
insured individual may neglect preventive health care, knowing that the costs of illness and/or
injury are covered. Second, when health care is needed, the insured may overconsume, because
the out-of-pocket expense for any single service is subsidized by the insurance. Providers may
also be encouraged to order more tests or treatments than are really necessary when the patient is
not having to bear the entire cost directly.
36-12 What is the rationale for exempting a firm’s contribution to its workers’ health insurance from
taxation as worker income? What is the impact of this exemption on allocative efficiency in the
health care industry?
The underlying rationale is that spillover benefits exist from a healthy, productive workforce.
Therefore, it is appropriate to make health care more widely available to workers and their
families. The impact of the exemption is to make private health care insurance more accessible
to more people, but it also contributes to the overconsumption problem. Workers in the 28
percent marginal tax bracket can essentially receive $1.00 worth of insurance for a contribution
of $.72, which is the after-tax value of that $1.00 in income spent on health insurance. The tax
subsidy costs the Federal government an estimated $65 billion in forgone revenue and boosts
private health insurance spending by about one-third. Health care spending may be 10-20
percent higher than it would be without the tax break.
36-13 Comment on or explain.
a. “Providing health insurance to achieve equity goals creates a tradeoff with the efficient
allocation of resources to the health care industry.”
b. “Improved health habits are desirable, but would not necessarily reduce health care costs.
For example, the deaths of many smokers are from sudden and lethal heart attacks and are
therefore medically inexpensive.”
c. “If government were to require employer-sponsored health insurance for all workers, the
likely result would be an increase in the unemployment of low-wage workers.”
(a) If equity means that society has a right to decent health care and universal access is a goal,
then there will be a tradeoff with the efficient allocation of resources. Under every universal
access proposal, there is some incentive toward overconsumption of health care resources,
since by definition of universal access, some people are being provided with access to health
The Economics of Health Care
care they would otherwise not care to purchase. By providing universal access, all who have
coverage find health care available at a lower “out-of-pocket” price than would be the case if
there were no insurance and health care prices were determined on the private market. Thus,
the quantity demanded will be greater than that justified by the cost of providing the services.
(b) This statement is true only for those few who may die from sudden, lethal heart attacks.
Poor habits, such as smoking, lead to increased health care costs for the majority who do
follow healthy lifestyles. Long-term health care problems, which lead to absenteeism and
lower productivity in the work force, spells of hospitalization from related illnesses, and
heart problems that do not result in sudden death, may occur. In considering smoking
specifically, there is also the potential for causing damage to the health of others through
secondhand smoke in the air.
(c) This statement is based on the view that many low-wage workers have low productivity, and
their employers are paying them according to the theory of marginal revenue productivity—
in other words, the low wage is equivalent to the value each contributes to the employer’s
output. To require health insurance coverage, is, in effect, raising the cost of each worker
and the employer could not afford this without some increase in the worker’s marginal
revenue product. While the statement seems true on the surface, if every employer faced the
same requirement, it may have the same result as minimum wage laws, and that is that only a
very small increase in unemployment results.
36-14 Briefly describe (a) “play or pay”; (b) tax credits and vouchers; and (c) national health insurance
as means of increasing access to health care. What are the major criticisms of national health
(a) “Play or pay” refers to the proposal whereby employers must either provide health insurance
to their employees (play) or pay a tax into a public insurance fund for those employees not
(b) The tax credit or voucher proposal is to give access to those who cannot now afford private
insurance. Low-income households would be given a credit to use for health insurance, thus
reducing their tax by the cost of the insurance. The poorest households, for whom a credit
would not apply, would be given vouchers to use in purchasing private health insurance in
much the same way as food stamps are used to purchase food.
(c) National health insurance would provide a basic package of health care to every citizen at no
direct charge or at a low-cost sharing level. It would be financed by tax revenues. Private
insurers could continue to offer health coverage for procedures not covered by the national
health insurance package.
Critics of national health insurance charge that government-controlled fees are not likely to
control costs, since providers can circumvent the low fees by ordering more procedures, more
frequent visits, and so forth. They also point to excess demand for health care in countries where
national health insurance exists. In Canada, the government’s efforts to control costs have
resulted in a shortage of technology and other services available to meet the demand. Critics
argue that the Federal government does not have a good track record in cost containment.
Finally, they fear some of the redistributional effects of national health insurance, which would,
by and large, result in a more progressive tax-subsidy structure, as low-income people would
receive more benefits and high-income groups would pay more into the system than the value of
the benefits they receive.
36-15 What are (a) preferred provider organizations and (b) health maintenance organizations? Explain
how each is designed to alleviate the overconsumption of health care.
The Economics of Health Care
(a) Preferred provider organizations (PPOs) are collective agreements among hospitals, doctors,
and insurance companies in which the providers (hospitals and doctors) agree in advance to
provide discounts on their services in exchange for receiving the business of those insured by
the company in question. Policy holders are given a list of those cooperating hospitals,
clinics, and physicians and will receive greater reimbursement by patronizing those members
of the PPO. Usually, the patient has a choice to receive care elsewhere, but at a lower
insurance reimbursement level.
(b) Health maintenance organizations (HMOs) are organizations which contract with employers,
insurance companies, labor unions, or other groups to provide medical care for their
members. HMOs alter the traditional fee-for-service arrangement by providing prepaid
health plans, which usually cover preventive care as well as sickness and injury.
PPOs lower costs by the agreement to lower fees in exchange for the contract from the insurance
company. The use of one organization can also lower administrative costs substantially, as
uniform medical forms and bills are streamlined. HMOs are considered “managed care”
systems, because utilization and spending are “managed” or controlled by close monitoring of
physician and provider behavior to eliminate unneeded tests and treatments, since HMOs operate
on a fixed budget. The existence of a budget for HMOs, which don’t charge on a fee-for-service
basis, provides an incentive to economize on services offered to each patient. Furthermore, by
encouraging patients to receive preventive care, HMOs might also reduce the higher cost of the
hospitalization of ill patients.
36-16 Do you think prescription drugs should be covered under Medicare? Are you willing to pay a
higher social security/Medicare tax to pay for this added benefit? Do you think the prescription-
drug benefit should go to everyone covered by Medicare, including those who can easily afford
to pay for the prescription drugs out of pocket?
Prescription drugs are becoming a more significant part of health care costs and are claiming a
larger share of the income of older Americans. Some older Americans must sacrifice necessities
to pay for prescription drugs or choose to do without the drugs even when they are required to
maintain health. Personally, I am willing to pay a higher Medicare tax. As with social security
and Medicare, the benefit should be considered a social insurance program and be available to all
who are Medicare eligible.
36-17 Which of the following groups do you think would favor limits on “pain and suffering” awards in
suits against HMOs and doctors: health insurance companies, advocacy groups for patients’
rights, physicians, trial lawyers? Explain.
Health insurance companies and physicians would favor such limits. Large “pain and suffering”
awards increase costs and reduce profits for these groups. Trial lawyers would definitely oppose
limits as they often are paid on contingency, receiving a percentage of the award as
compensation. Patients’ rights groups would tend to oppose limits, as they would keep victims
of malpractice from receiving what they believe they are entitled to, as well as reducing the cost
of committing malpractice (thus increasing the likelihood of it occurring). At the same time
patients’ rights groups may also have an interest in keeping costs down to make health care more